In the past I have
noted that as prices rise, so does risk, and conversely, as prices decline, risk
evaporates.

Here is the
question:are the risks right now
greater in stocks or in bonds?We
have had thirty-plus years of falling rates (meaning rising bond prices), and we
have had more than four years of exuberant, soaring stock prices, leaving us at
very high risk levels in both sectors.

In bonds today
there is a general feeling that rates will rise and bond prices will fall as a
result.That seems to be a premise
with a sound foundation.After all,
rates hovered at about as close to zero as one could expect for quite a long
time, and recently they have begun to move, and sharply, the only way they
could--up.

So for the moment,
let’s assume the case, that rates continue to rise.

I often play a
game that I call “If-Then.”It
is a simple q and a:if this
happens, then what can we expect?Thus
I ask:if rates rise, then what
happens to stocks?Most people
focus only on the effect rising rates will have on bonds, but I can tell you
that all asset classes are affected.

Now anyone with a
smidgen of debate in them will recognize that if the “if” premise is
incorrect, then the “then” assumption will necessarily be wrong.But we have no choice; we must always make assumptions about the future
based upon our best knowledge at the moment, and we must plan according to those
assumptions, even if God does laugh.

Bond pricing may
be somewhat formulaic:we input
parameters, e.g., the coupon, maturity, and quality, and then, using the general
level of interest rates, we can arrive at an approximate price level.We can adjust pricing for expectations of moves in rates.And we know with certainty that if rates rise then bond prices fall.

Stock pricing, far from being
formulaic, is notoriously perverse, with a multitude of inputs.

Among that
multitude of factors a major component is the P/E (price-earnings) ratio.Stated as simply as possible, a business is worth some multiple of it’s
earnings.What should thatmultiple be?It is different for different industries, and it also varies according to
expectations, macro and micro.Further, it will typically be higher for companies with no debt versus
debt-heavy companies; higher for younger companies versus established firms;
higher for growth; and so on.We
have had long periods of excess in overall valuations, both high and low, and
long periods of non-correlation.Psychology
plays a larger part than we like to admit.

Still, the
multiple that one might logically be willing to pay for a business is dependent
upon the general level of interest rates:the
higher the rate the less you will be willing (or able) to pay.Thus if rates go up, all else equal, then stocks can be expected to come
down.In fact, the starting point
for calculating the P/E ratio is the inverse of interest rates: higher rates
mean a lower P/E.

Stocks are often
said to follow the trend of their earnings over the longer term.You can argue this, and you can argue that there is no science to stock
pricing.The stock of Microsoft has
basically flatlined for the last decade-and-a-half,
a period that saw their earnings soar.(So
much for prices following earnings over the longer term.)During that period rates came down, but so did the P/E of
MSFT.As I said, stock pricing is
perverse, it is anything but formulaic.MSFT
is just one example proving that there are no hard-and-fast rules.

But now let’s
come back to the basic “if-then” premise.Remember that if the “if” premise is incorrect, the “then”
assumption will not be accurate.

In this case, the
“if” is that rates rise, something that I have thought imminent for six
years.And they have finally done
so.But what if they do not
continue to rise?If you find it impossible to imagine that rates stay
depressed for much longer, ask yourself how palatable it might be to any
political party to allow rates to rise dramatically; ask yourself to remember
Japan, where rates were miniscule for two decades.Remember that anything is possible, however improbable it may seem.

I realize that I
have not answered the question of which asset class is riskier.I have no answer, and I offer only the discussion.But I will say that I do expect rates to rise, and that it is pretty much
a given that this year will be great for stocks but not great for bonds.

But that is now
history.We must input all of our
knowledge and look forward.We are
apparently at a vulnerable point in all markets, and I am charged not only with
making your money grow, but also with protecting it from decline.It is a task that I take very seriously.